ME -Business Objectives and Models of the Firm - 10

7/30/2019 ME -Business Objectives and Models of the Firm - 10

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Managerial Economics

BUSINESS OBJECTIVES AND MODELS OF THE FIRM i

This chapter considers a variety of different models of the firm, based upon differentassumptions about the firm's basic objective. The neo-classical economic model of thefirm is developed first and then the chapter goes on to examine some of the criticisms

which have been directed at that model, and some of the alternatives which have been putforward in its place.

THE NEO-CLASSICAL ECONOMIC MODEL OF THE FIRM

There are many different models of the firm, embodying many different assumptions,which could be described as 'economic' models. However, there is one particular version,which forms the mainstream orthodox treatment of the firm, to be found in everyintroductory textbook. This centers around three basic sets of assumptions concerning theaim of the firm, and its knowledge of the cost and demand conditions facing it.

The assumption of profit-maximization

The first component of the neo-classical model of the firm is the assumption that theobjective of the firm is to maximize profits, defined as the difference between the firm'srevenues and its costs. In this simple form the assumption is too vague, because it makesno reference to the period of time over which profits are to be maximized. This may beresolved in one of two ways. The simplest is to see the model as a one-period or short-runmodel, where the firm's assumed aim is to make as much profit as possible in the shortrun. The short run, it will be remembered, is defined by economists as the period inwhich the firm is restricted to a given set of plant and equipment, and has some fixedcosts which cannot be avoided even by ceasing production.

A slightly more complex version, which establishes a multi-period setting for the model,is to assume that the objective of the firm is to maximize the wealth of its shareholders,which in turn is equal to the discounted value of the expected future net cash flows intothe 1'irm. In this case, the firm can be thought of as facing two interrelated kinds ofdecision. First, it has to take long-run or investment decisions on the level of capacity andthe type of plant it wishes to install. Second, it has to decide upon the most profitable useof that set of plant and equipment. These short-run, capacity utilization, decisions areessentially the same as those facing the firm maximizing profits in the short run, and thesame analysis applies- If the profits made in each period are independent of each other,the single-period and multi-period models will be consistent with each other. However,there is a more difficult problem if the profits made in the current period could have aninfluence on the profits made in the future, because in that case it is possible thatshareholders' wealth could be maximized by sacrificing profits in the current period.

For instance, if a firm has a monopoly position, the maximum profit possible in thecurrent period may be very large. However, if the firm uses its monopoly power to makethat maximum profit, other firms may be attracted into the industry, or it might draw theattention of the anti-trust authorities. In either case, it is possible that the maximization ofshareholders' wealth will be better achieved by not taking the maximum profit available

This material is adopted for instructional purposes by Dr. Tadesse Negash. See footnore. 1


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in the short run. The simple neo-classical model of the firm does not consider suchcomplications, being essentially concerned with the maximization of short-run or singleperiod profits.

The assumption of profit-maximization gives the basic model of the firm a number ofcharacteristics which distinguish it from other models. In the first place, it identifies a

model which is 'holistic' in the sense that, however large and complex, the firm is seen asa single entity which can be said to have objectives of its own and which can be said totake decisions. This is in marked contrast to the 'behavioral' model of the firm, where it isargued that 'only people can have objectives, organizations cannot', and to the'managerialist' model where it is argued that managers and shareholders have differentand conflicting objectives.

The second characteristic of the model, which also stems from the assumption of profit-maximization is that it is an 'optimizing' model, where the firm is seen as attempting toachieve the best possible performance, rather than simply seeking 'feasible' performancewhich meets some set of minimum criteria. Again, this is in contrast to the behavioral

model and to many quantitative techniques in operational research or operationsmanagement, which seek merely to identify feasible, rather than optimal solutions toproblems.

Costs and output

The second component of the textbook model of the firm concerns the nature of the firm'sproduction and the behavior of costs, considered in more detail in [another chapter]. Thefirm is assumed to produce a single, perfectly divisible, standardized product for whichthe cost of production is known with certainty. In the short run, when some costs arefixed, the average cost curve will be U-shaped, as shown in Fig. 3.1.

Cost per unit fails over the range A to B, as the fixed costs are spread over a largernumber of units, but begins to rise beyond B as the principle of diminishing returns leadsto increasing variable costs per unit.

Cost

A Short-run average cost

B

Output

Fig. 3.1 The short-run cost curve

As the textbook model is essentially concerned with the short-run situation, it is short-runcost curves which are most relevant, and which are shown in the diagrams. The model



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depicts a firm, which is attempting to maximize its profit with respect to a particular setof plant and equipment, which has a particular short-run cost curve. If we also wish toconsider long-run decisions then attention needs to be paid to the behavior of costs in thelong run, considered in more detail in [another chapter].

Demand conditions

The third component of the orthodox model of the firm is the assumption that the firmhas certain knowledge of the volume of output, which can be sold at each price. These'demand conditions' are considered in more detail in [other chapters]. For the purposes ofthis chapter it is sufficient to note that demand depends upon two sets of factors. First, itdepends upon the behavior of consumers, which determines the total demand for theproduct. Second, it depends upon the structure of the industry in which the firm isoperating, and the behavior of rival sellers. The simplest example to consider is that ofthe monopolist, where there is only one supplier of the product in question. In that case,consumer demand for the product can only be met by the single firm in the industry andthere is no distinction between the total demand for the product and the demand for the

individual firm. There is only one demand curve for the firm and the industry. Theprecise shape of that curve depends upon the nature of the product in question, thenumber of consumers in the market concerned and their incomes, wealth and tastes.However, as the analysis in another [chapter] shows, it can generally be assumed that thedemand curve will slope downwards from left to right, indicating that more of theproduct can be sold at lower prices.

Equilibrium in the profit-maximizing monopoly model

Having assumed profit-maximization, and certain knowledge of cost and demandconditions, it is possible to move on to the second stage of model building, which is todraw out the implications, or predictions, which follow from the assumptions. Themethod of reasoning used to do this is essentially that of the mathematician. It is assumedthat the problem has been solved, and then the conditions which must therefore hold areexamined. The mathematical formulation of the model can be simply set out as follows:

Maximize $(q)

Where $(q) = R(q)-C(q) where$(q) = profitR(q) = revenueC(q) = costs

q = units of output sold

Translated into words, this formulation simply means 'maximize profit where profit isequal to revenue minus costs, and where costs and revenue each depend upon the amountof output which is sold.' Elementary calculus shows that if profit is to be maximized, thefollowing conditions have to hold.



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Condition 1 d$ / dq = dR / dq - dC / dq = 0.

or dR / dq = dC / dq.

Condition 2: d2R / dq2 > d2C / dq2

Again, restating these equations verbally, profit will be a maximum if the firm producesthe level of output such that marginal revenue (dR/dq) equals marginal cost (dC/dq)and when the slope of the marginal cost curve exceeds the slope of the marginal revenuecurve. This rather formal presentation of the model can be expanded upon using adiagrammatic version, shown in Fig. 3.2.

In Fig. 3.2, the profit-maximizing level of output is X and the profit-maximizing price isP. The reason for this is simply explained without resort to mathematics. The decisionwhich the firm is facing concerns the level of output, which should be produced and soldusing the set of plant and equipment which it has installed. (The simple model alwaysassumes that sales volume and output are equal, taking no account of the possibility of

producing to stock or selling from stock.) It will pay the firm to produce any unit ofoutput for which the extra revenue earned (marginal revenue) exceeds the extra cost(marginal cost). At level of output X all such units are being produced. If output isincreased further, the additional units produced will add more to costs than to therevenues, and the level of profit will fall.

The diagram and the equations set out above identify the profit-maximizing equilibriumfor the firm. In the short run, under the assumptions made, the firm will produce theindicated level of output and sell it at the indicated price. If cost and demand conditionsremain the same, the firm has no incentive to alter its price or output, and the firm is saidto be in equilibrium.

Marginal cost curveP

Demand / averagerevenue curve

X OutputMarginal revenue curve

Fig. 3.2 Profit maximizing equilibrium



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Applications of the simple model

The model which has been developed above may be used in a number of ways. Itspurpose on mainstream economic theory is essentially to predict how a form will respondto charges in its environment. If some aspect of the environment changes, the modelindicates the ways in which the firm will respond in order to move to a new equilibrium.

For instance, if demand increases, both price and output will increase. If costs rise, pricewill fall. Fig 3.3 shows the comparative static properties of the profit-maximizing model.

Change Impact on

Price Output

Demand increase + +Demand fall - -Increase in variable cost + -Lump sum or cost increase 0 0

Fig 3.3 Comparative static properties of the profit-maximizing modelIn addition to these 'positive' uses of the model, it is sometimes also used for 'normative'purpose, providing prescriptions telling managers what they 'ought to do' in certaincircumstance. For instance, the finding that a firm seeking maximum profit shouldproduce every unit of output for which the managerial revenue exceeds marginal cost isoften presented as just such a prescription, and extended in the management accountingliterature into the similar finding that firms should always agree to accept business whichbrings in greater incremental revenue than incremental cost. Such prescriptions are valid,provided that the firm is attempting to maximize profit, and the assumptions of the modelare completely fulfilled. If they are not, however, it could be extremely dangerous toadopt the prescriptions without further thought.

Profits in the long run: the maximization of shareholders' wealth

The profit-maximizing model set out above is concerned with capacity utilization and theshort run. The firm has some fixed costs, arising from a given set of plant and equipment,and is concerned to make as much profit as possible, given the constraints set by thatequipment. However, the firm also has to take investment decisions, which are concernedwith the long run, in which no costs are fixed and when the firm is free to choosewhichever set of plant and equipment it prefers.

When considering these long-run decisions it is not sufficient to characterize the firm'sobjective as 'profit-maximization' because profit is defined as revenue minus opportunitycost in a single period, without reference to the pattern of returns over time. It might beargued very simplistically that long-run profit-maximization consists of maximizing thesimple sum of profits over a number of short periods, but that would leave theunanswered question 'over how long should profits be added up?'. More significantly,such a simple addition would give the same weighting to returns occurring at differenttimes, thereby ignoring the time-value of money [fuller explanation in another chapter].



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In order to avoid this difficulty, the long-run objective of the profit-maximizing firm issaid to be the maximization of shareholders' wealth, which is achieved by maximizing thevalue of the firm. This in turn is measured by the present value of the stream of expectedfuture net cash flows accruing to the firm. The restatement of the firm's profit objective inthis way allows the short run and the long run to be properly integrated. In the long run,as shown in [another chapter], the firm decides upon the set of capital equipment to

purchase by using investment appraisal techniques based upon the calculation of presentvalues. However, these calculations themselves require estimates of the revenues andcosts which are associated with each investment project, on the assumption that theequipment, once purchased, will be used to secure maximum pro fit. Choosing a set ofcapital equipment in the long run therefore requires the solution of the short-runquestions concerning revenues, costs and profits in the short run.

If the profits earned in each period, or each short run, are independent of each other, thenthe maximization of profit in each period will lead to the maximization of shareholders'wealth. However, as noted in the section on the assumption of profit-maximization earlierin this chapter, if profits in one period depend upon profits in another, there may be a

conflict between the two objectives. A firm with a monopoly position might makemaximum profit in the short run by exploiting that position to the full, but in doing so itmight attract entry to the industry, or anti-trust action from government, which wouldreduce profit in future periods. Maximizing shareholders' wealth could require thesacrifice of immediate profits in order to protect their value in the longer term, dependingupon the shape of the time-stream of profits, and the discount rate used to calculatepresent values. As the long-run objective, formulated in present value terms, takesaccount of the relative weighting lo be given to profits accruing at different times, iishould be given priority if such a conflict between objectives arises.

MANAGERIAL DISCRETION MODELS OF THE FIRM

'Managerial criticisms of the profit-maximizing model

The textbook model of the profit-maximizing firm has been criticized on a number ofdifferent grounds. Perhaps the best known of these centers around the claim that it isunrealistic to assume that firms aim for maximum profits in a modern economy whereownership and control of firms lie with different groups of individuals. The pioneeringwork of Berle and Means (1932) in the United Slates demonstrated clearly that themodern corporation was not simply a larger version of the owner-managed firm, but thatownership and control had become separated. Control lay in the hands of professionalmanagers while ownership rested with shareholders. If the interests of shareholders andmanagers differ, if shareholders have relatively limited information about theperformance of the firms they own, and if shareholders take relatively little interest in thefirms' operations, provided a satisfactory dividend is paid, then managers may have agood deal of 'discretion' to pursue their own objectives. This will be particularly truewhere firms have some degree of monopoly power and do not have to compete keenly inorder to make a satisfactory level of profit. It has been suggested, therefore, that inoligopolistic markets, firms do not pursue profit as their major objective.



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The suggestion that profit is not the objective of modern corporations has led to thesearch for alternative models based upon different assumptions about the firm's objective.There are many such models, but the best-known are:

the sales-revenue-maximizing model, developed by Baumol (1958) the managerial-utility-maximizing model (Williamson (1963) the multi-period profit-maximizing rate of growth model (Baumol (1967))

the Marris model (Marris(1964)) J.Williamson's integrative model (1966)

Each of these merits some attention.

Baumol's sales revenue-maximizing model

Baumol's model stems from the observation that the salaries of managers, their status andother rewards often appear to be more closely linked to the size of the companies inwhich they work, measured by sales revenue, than to their profitability. In that case,managers may be more concerned to increase size than to increase profits, and the firm's

objective will be to maximize sales revenue rather than profits.

If the assumption of profit-maximization is replaced by that of sales-revenue-maximization, then a different model results. In many respects, ii shares fundamentalcharacteristics with the standard model, as it is also an optimizing model in which asingle product firm aims for a single objective, having perfect information about its costand demand conditions. Nevertheless, the details are different, as illustrated in Fig. 3.4,which sets out the basic version of the model, using total revenue, total cost, and profitcurves.

In Fig. 3.4, the firm will choose to produce level of output A, giving total revenue B andprofit C. Note that this implies a higher level of output, and therefore a lower price, thanthe equivalent profit-maximizer, which would produce output D and earn revenue E. Astraightforward revenue- maximizer will always produce more and charge less than aprofit-maximizing firm lacing the same cost and demand conditions for the followingreason:

for revenue-maximization marginal revenue =0 for profit-maximization marginal revenue = Marginal cost as marginal cost must be greater than 0, then for a profit-maximizer: marginal

revenue must be greater than 0 therefore marginal revenue for a profit-maximizer must be greater than marginal

revenue for a revenue-maximizer as marginal revenue slopes downwards to the right, equilibrium output must be

higher for a revenue maximizer than for the profit-maximizer.



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Total cost

B

E Total revenue

C

D A OutputProfit

Fig. 3.4 Baumol's revenue-maximizing model

As it happens, in Fig. 3.4, the sales-maximizer also makes some profit. However, thismay not be enough to satisfy the shareholders, and in many cases maximizing revenuemay imply making losses. As a result the simple revenue-maximizing model isimplausible, and the model needs to be amended lo include a profit constraint. Instead ofsimply assuming that the firm aims for maximum revenue, without regard to theimplications for profit, it is assumed that the objective is the maximization of salesrevenue, subject to meeting a minimum profit constraint. This version is shown in Fig.3.5.

Total cost

Total revenue

PC3PC2PC1

C B A Output

Profit

Fig. 3.5 Revenue-maximization, subject to constraints



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As the figure shows, there are three possible cases in this amended version of the model.The first is where the profit constraint is as shown by the line PC I. In this case theconstraint does not 'bite'- At the level of output, which maximizes revenue, enough profitis made to satisfy the shareholders. The second case is where the profit constraint is asindicated by PC2. In this instance, at the revenue maximizing level of output, insufficient

profit is made to satisfy the shareholders and output is reduced until that constraint is met,at level of output B, The third case is where the minimum profit required to satisfy theshareholders is equal to the maximum profit which can be made, in which case the firmhas to reduce its output to C. In this third case, the firm behaves in exactly the same waywith respect to its output and price as a profit-maximizer, despite the fact that it has setitself a different objective. This is an important point, which takes the analysis back to apoint made above in the discussion on the purpose of models. If shareholders insist uponthe maximum level of profit being earned, then the profit-maximizing model will provideaccurate predictions of the behavior of a firm whose management prefer to maximizesales revenue. If the purpose of the model is to predict the firm's behavior the fact thatmanagers see their aim as maximizing sales revenue, and not profit, is irrelevant. The

firm behaves 'as if' it were a profit-maximizer.

The revenue-maximizing model can be compared to the profit-maximizing mode withrespect to its comparative static properties, which reveals both similarities anddifferences. If demand increases, both types of firm respond in the same way, with anincrease in output and price. On the other hand it has been shown above for a profit-maximizer that if fixed costs increase, or a lump-sum tax is imposed, price and outputwill not change. However, for a revenue-maximizer whose profit constraint is alreadybiting, a lump-sum tax will reduce profits and will force the firm to lower its output andraise its price.

The managerial utility-maximizing model

In Baumol's sales-revenue-maximizing model, managers' interests are tied to a singlevariable, with the addition of a profit constraint. Williamson's managerial-utility-maximizing model takes account of a wider range of variables by introducing the conceptof 'expense preferences' and beginning with the assumption that managers attempt tomaximize their own utility. The term 'expense preference' simply means that managersget satisfaction from using some of the firm's potential profits for unnecessary spendingon items from which they personally benefit, Williamson identifies three major types ofexpense from which managers derive utility. These are:

1 The amount, which managers can spend on staff, over and above those needed torun the firm's operations (S). This variable captures the power, prestige, status andsatisfaction which managers' experience from having control over larger numbers ofpeople.

2. Additions to managers' salaries and benefits in the form of 'perks' (M). Theseinclude unnecessarily luxurious company cars, extravagant entertainment and clothingallowances, club subscriptions, palatial offices and similar items of expenditure. Suchitems may also be thought of as 'managerial slack' or 'X-inefficiency' (see below). They



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appear as costs to the firm, but are not necessary for the efficient conduct of its activitiesand arc in effect coming out of profits.

3. Discretionary profits (D). These are after-tax profits over and above the minimumrequired to satisfy the shareholders. They are therefore available to the managers as asource of finance for 'pet projects' and allow the managers to invest in developing the

firm in directions, which suit them, enhancing their power, status and satisfaction.

Clearly there are conflicts and trade-offs between the different objectives in this model,and it is considerably more complex than those considered thus far. The detailedworkings of the model go beyond the requirements of this text. Nevertheless, the mainoutlines are reasonably accessible. The basic form of the model is as follows:

U = f (S, M, D) - managerial utility (U) depends upon the levels of S, M and Davailable to the managers.

In common with the utility theory of consumer behavior ii is also assumed that the

principle of diminishing marginal utility applies, so that additional increments to each ofS, M and D yield smaller increments of utility to the management.

If R = Revenue, C = Costs and T=Taxes then

Actual profit = R - C -S

Reported profit = R - C - S - M

If the minimum post-tax profit required by the shareholders is Z, then:D = R - C - S - M - T - Z

The solution to the model requires a fairly complex use of calculus in order to maximizethe utility function (see Reekie and Crook (1982) for an attempt at a geometricalexposition). However, it is possible to set out a simplified version.

If managerial utility is to be maximized, the last pound spent on S, M and D must yieldthe same marginal utility, i.e.:

MUs=MUM = MUD(I -t) Where t is the rate of tax on profits.

This can be used to examine some of the comparative static properties of the model.

If demand declines, then at every level of output D will decline. On the assumption ofdiminishing marginal utility, MUD will rise, so that the equilibrium condition is no longerfulfilled. To regain equilibrium the available profits will be redistributed towards D andaway from S and M. The level of output will fall. Similarly for a rise in fixed costs, or alump-sum tax.

If the tax on profits increases then MUD(l - t) will fall and so there will be a shift towardsS and M, accompanied by increasing output.



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The complexity of the Williamson model can make it difficult to examine in every detail.However, it does have an interesting application in explaining how take-overs are oftenfollowed very quickly by increases in reported profits. If the new management teamexhibits a weaker preference for S and M, both of which entail unnecessary costs, theywill prune these in line with their own preferences and will be able to very quickly report

higher profits without too much difficulty and before altering any of the fundamentals ofthe business.

As in the case of the Baumol model, it should always be remembered that the usefulnessof the model depends upon the management team having the discretion to earn less thanmaximum profits. If the minimum profit required by the shareholders is equal to themaximum possible, the managers will not have the discretion to indulge their taste for'perks' and unnecessary staff.

The profit-maximizing rate of growth model

Both of the models set out above are static in that they contain no reference todevelopments over time and the equilibria identified involve sales, profits and utilitiesremaining constant unless preferences or outside circumstances change. In addition; tosuch static models there are a range of dynamic models, which consider growth overtime in a multi-period selling.

One such model is the profit-maximizing rate of a sales growth mode, developed byBaumol (1967). In this analysis the aim of the firm is 10 maximize the present value ofexpected future profits, which is simply the difference between the present value ofexpected future revenues and the present value of expected future costs, as shown in Fig.3.6.

PVR

PVC

Present value of maximum profit

g* Rate of growth (g)

Fig. 3.6 Profit-maximizing rate of growth



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The present value of costs (PVC in Fig. 3.6) is made up of two components. First thereare the costs of producing output, including both the fixed and variable costs of operation[with more details available in another chapter]. Secondly, there are the costs associatedwith expansion, especially those concerning the development of a management teamcapable of controlling a larger organization, and those involving the raising of finance.While the costs of production may rise proportionately with growth it is assumed that

expansion costs will rise more than proportionately as the growth rate rises, so that PVChas the shape shown in Fig. 3.6, becoming increasingly steep.

The curve showing the present value of expected future revenues will also tend to beupward sloping, with an increasing slope. Whatever the discount rate used to calculatepresent values, the present value of future revenues will be larger as the growth rate ofsales volume is larger. A relatively simple mathematical manipulation (see Reekie andCrook (1982) pp.61-62) shows that the slope of the line increases with the growth rate.

In this model the decision variable is not the level of output, but the growth rate ofoutput, selected in order to maximize the present value of future profits, given by rate of

growth g*, where the vertical distance between the revenue and cost curves is at itsgreatest.

The Marris model

The Marris model (Marris(1964)) is also dynamic in that it concerns growth rates but itshares the basic assumption of the Williamson model that managers aim to maximizetheir utility. However, instead of managers gaining utility from expense preference, inthis case it is assumed that their utility depends upon the rate of growth of the firm. Whilegrowth is their main aim, managers arc also motivated by the need for job security, whichdepends upon the satisfaction of the shareholders, who are assumed to be wealth-maximisers concerned to keep share prices and dividends as high as possible. Growth andprofitability are therefore the key variables in this model.

Growth in the Marris model is assumed to take place through diversification into newproducts, rather than an increase in the output of existing products, and the relationshipbetween growth and profitability has two dimensions. First, there is the 'supply-growth'dimension where growth is a function of profits. A higher level of profits provides morefunds directly for reinvestment and also allows more funds to be raised on the capitalmarkets and therefore allows a higher rate of growth to be funded. This gives a direct andpositive relationship between growth and profits, shown in Fig. 3.6 as a straight line.

Secondly, there is the 'demand-growth' relationship which operates in the other,direction, with growth determining profits. This is more complex. As growth consists ofdiversification into new products the links between profits and growth are seen asdifferent at different levels of growth. At low levels of growth it is argued that therelationship is a positive one, with more growth providing more profits. At these levels itis argued that the firm will be introducing the most profitable new products from thosewhich are possible and managers will be motivated to be more efficient by more growth.However, as the growth rate increases, with ever greater diversification, the relationshipchanges and becomes negative. The management team has to cope with increasingburdens, including the development of a larger management team, the higher rate of



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diversification can only be maintained by proportionately higher expenditures onadvertising and research and development. As a result, beyond a certain growth rate,higher growth leads to lower profitability. The resulting relationship is shown in Fig. 3.7.

As both the 'supply-growth' and 'demand-growth' relationship must be satisfied, thecombination of growth and profitability which the firm achieves must be where the two

curves intersect, at point X.

In the example shown in Fig. 3.7 the combination of profitability and growth chosen isnot one where profits are maximized. The managers' desire for growth, from which theygain utility, has encouraged them to seek more growth than is consistent with profit-maximization. However, the extent to which they do this depends upon the strength oftheir desire for job security, which may be threatened if the shareholders feel that theirwealth is not being maximized and if there is an active threat of take-over by other firms.This will affect the position of the 'supply-growth' relationship, through the retention ratioand the price of the firm's shares.

SG1Supply growth

B

A

X

Demand growth

Growth rate

Fig. 3.7 The Marris model

If the retention ratio is very low, so that nearly all profits are distributed to theshareholders, then at every level of profitability, growth will be low, as there is limitedfinance for expansion. The supply-growth curve will be very sleep, as shown by SG1 inFig. 3.7. The equilibrium of the firm will be at a point like A, where less than maximumprofit is earned and growth is relatively low. As the retention ratio rises, the supply-growth curve becomes flatter as more growth can be financed from retained earnings at

each level of profitability. As a result, as the retention ratio rises, so does the equilibriumcombination of growth and profitability until it reaches point B where profits aremaximized. Up to this point the managers need have no fears for their job security as thecombination of higher profits and higher growth must meet with the approval of theshareholders. However, if the managers of the firm wish to adopt even higher retentionratios, giving even higher growth then they need to pay careful attention to the impact onthe wealth of shareholders. A further increase in retentions will reduce dividends becauseprofits will be lower and the proportion of those distributed in dividends will be lower. Inso far as share prices are determined by both dividends and the firm's growth rate it will



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probably be possible to go some way beyond point B without the firm's share pricebeginning 10 fall. However, at some point the effect of still higher retentions, creating aneven flatter supply-growth curve and yet lower profits and dividends will be to reduce theshare price and the value of shareholders' wealth, rendering the firm vulnerable to take-over and threatening the job security of the incumbent management. The actual positionof the supply-growth curve will depend upon how real the threat of take-over is perceived

to be and the relative preferences of managers for job security and growth. If the threat oftake-over is perceived to be very powerful, and managers place a high value on jobsecurity then they will not push the firm beyond the point where shareholders' wealth andthe share price is maximized. However, if the threat of take-over is perceived to be weak,and managers place a high value on growth relative to job security, they will adoptretentions policies, which give higher growth and lower profits than those, which wouldbe optimal for the shareholders.

J. Williamson's integrative model

Each of the models outlined above has been based around a single objective function in

either a single-period or a multi-period setting. A number of these may be broughttogether in Williamson's integrative model, which combines single period profit andsales-maximization with growth-maximization and the maximization of the present valueof future sales. All of these are shown in Fig- 3.8.

pv1 pv2 pv3Rate of sales revenue g1

growth (%) g2

0 Current sales revenueQ1 S1 S2 S3 costs and profits()

Q2Quantity

Q3 TC

PCext TR

PCint.

Fig. 3.8 An integrative model

The lower part of the diagram in Fig. 3.8 shows total cost, revenue and profit in a singleperiod, along with the profit constraint required in the Baumol model. The upperquadrant shows the relationship between the rate of growth and current sales revenue.Growth of sales revenue is assumed to be directly related to profits, so that growth ismaximized when profits are maximized and growth is zero when profits are zero. Asingle-period profit-maximizer and a sales-growth maximizer will therefore both produce



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level of output Q1. A single-period revenue-maximizer, subjected to the externallyimposed profit constraint, PCext will produce a higher level of output Q2.

A firm which aims to maximize the present value of future sales will seek thecombination of current revenue and growth rate which gives that maximum. This can befound in Fig. 3.8 by constructing 'iso-present-value' curves joining all points which have

the same present value. As the present value increases with both the growth rate and thecurrent sales value the maintenance of a constant present value requires that a highergrowth rate be combined with a lower current value of sales and vice versa. The 'iso-present-value lines' must therefore be negatively sloped as shown in the diagram by thelines PV1 to PV3. Higher present values are' given by lines, which are further away fromthe origin and the present value of sales is maximized at point X. This must lie 10 theright of the profit-maximizing position, by virtue of the downward slope of the 'iso-present-value' lines, so that a firm which aims to maximize the present value of sales willalways choose a level of output which exceeds that of the profit-maximizer. If the firm isto achieve its maximization target it must grow at rate 'g 2', which requires the level ofcurrent profit given by the profit constraint 'PCint', which is an internally imposed profit

constraint set by the management in recognition of the need to achieve growth rate 'g2.In the diagram shown, the internally generated profit constraint is lower than thatimposed externally. Maximizing the present value of sales requires an output levelgreater than Q2 and there is a conflict between the firm's desire for a higher level of salesand the need to meet the profit constraint. The outcome of that conflict depends upon theextent to which the managers of the firm have the discretion to pursue their ownobjectives when they conflict with others.

IN DEFENSE OF THE PROFIT-MAXIMIZING MODEL

The methodological defense

The managerial models described above have their origins in dissatisfaction with theprofit-maximizing model arising from the claim that firms do not attempt to maximizeprofits in a world where ownership and control are separate and where the oligopolisticnature of markets gives firms a degree of monopoly power which cushions them from theneed to maintain profits at their maximum level.

Supporters of the orthodox model put forward a number of arguments in its defense. Inthe first place, falling back on a methodological argument outlined above, it can bepointed out that the descriptive realism of an assumption is not a valid criterion on whichto judge a model. If the purpose of a model is to predict, rather than simply to describe,then the criteria for evaluating a model are quite clear. First, the model must yieldpredictions, which the profit-maximizing model does. Second, those predictions shouldbe testable against the data, which is a test the model also passes. Third, the predictionsshould be supported by the data, which its supporters would claim is also the case. If thisproposition is accepted, then the basic argument of the managerial school is ill-founded,as the realism of the profit-maximizing assumption is quite irrelevant.



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Links between ownership and control

Despite the apparent strength of the methodological argument, many economists continueto be uncomfortable with the prospect of depending upon a model based upon anunrealistic assumption. Other defenses of the profit-maximizing model have suggestedthat the basic assumption is in fact much more realistic than the managerialist arguments

suggest.

In the first, place ii may be noted that the separation between ownership and control,upon which the managerialist argument depends very heavily, is by no means as great asit might appear. Although shareholders and managers are clearly not exactly the same setof people, there is considerable overlap between the two. In most companies, thedirectors own shares in the firm and a substantial part of their total remuneration packageconsist of the returns on those shares in the form of dividends and increases in sharevalues. There is therefore a very important group of individuals who are bothshareholders and senior managers, bridging the gap between ownership and control. Ascompanies increasingly introduce profit-related bonus schemes, or give managers the

option to purchase shares, managers have an increasing direct personal interest in thefirm's profitability.

The power of institutional shareholders

A second strand in the managerialist argument is that shareholders are not well- informedabout the activities of the firms they own, and exhibit only minor concern about theirperformance, being disinclined to criticize or displace the incumbent managementprovided a moderate level of dividend is paid. This allows the management of a firm tobehave in ways, which suit the managers, but are not in the interests of the shareholders.In so far as shareholders are private individuals, with small shareholdings and limitedlime to spend monitoring their performance, this is a valid argument. However,ownership of shares is not typically spread across private individuals alone, but isfrequently concentrated in the hands of financial institutions like pension funds,investment trusts, insurance companies and other similar organizations. These institutionsdepend upon the financial performance of the firms in which they have invested in orderto attract funds and to survive and make profits themselves. They employ professionalmanagers to monitor their investments and use industry analysts (usually employed bytheir stockbrokers) to scrutinize the performance of the firms in which they haveinvested. Such shareholders are powerful, well-informed about the firms in which theyown shares, and extremely concerned about their financial performance. As a result theymay exert considerable pressure on managers to aim for maximum profit, removing thediscretion they must have if the managerial models are to apply.

Such arguments are, of course, subject to a number of qualifications. If the financialinstitutions themselves are under little competitive pressure they may in turn make onlylimited efforts to monitor and control the firms in which they own shares. A financialinstitution may become 'locked into' a firm in which it has a major financial stake, beingafraid to make public any doubts it has about the firm's policies and performance for fearof seeing a fall in the share price and a weakening of the performance of its owninvestment portfolio. The balance of the argument is not completely clear. Nevertheless,



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it is certain that in many circumstances pressure from shareholders may limit the extent towhich managers have discretion.

The 'market for corporate control'

Shareholders may exert direct pressure on the management of a company if they believe

it to be earning less profit than it could. The existence of a market for voting shares - themarket for corporate control - provides a source of indirect pressure in the same direction,through the working of share prices.

Share prices are determined fundamentally by the amount which investors are willing topay for them. For rational profit-seeking investors this amount will be equal to thepresent value of future profits. If a company's management is considered by the market tobe using the firm's resources to make less than maximum profit, the share price will belower than it would be if the management were more efficient. The firm and its assetswill therefore be undervalued, and the company will present a very attractive target to'take-over raiders', who may seek to buy up the relatively undervalued shares, shake-up or

dispose of the existing management, and use the firm's resources more effectively inorder to produce higher profits and a capital gain through an increase in the share price.

This form of discipline may work in two different ways. The most obvious one is wheretake-overs actually take place and lazy managements are displaced or disciplined by newowners with a greater concern for profits. Alternatively (see Holl (1977)) the threat ofpossible take-over may be enough in itself to act as a disciplinary force. In either case, theability of managers to exercise discretion over the ways in which the firm's resources areused is severely restricted.

Agent / principal relationships

A recent development in the theoretical analysis of the firm, which also suggests thatprofit-maximization may be a realistic assumption, is known as 'agency theory' (see Fama(1980) and Fox (1984)). In this approach the firm is seen as a network of contractsbetween the 'principal' and a group of 'agents'. The principal (who cannot have fullknowledge of all factors affecting the business) hires a group of agents to carry outcertain tasks (on which they will be better informed than the principal) and devises acontract, which may be partly unwritten and informal, to link the agent's performance tohis reward. Different types of contract and different sets of information will give theagent incentives to behave in different ways, and if contracts are 'efficient' then the agentswill choose to behave in ways, which suit the principal. The conditions under whichprincipal/agent relationships will be efficient are difficult to identify in detail, even at atheoretical level, but Fama suggests that contracts tend to be specified in ways, which doforce agents to direct their energies towards profit-maximizing activities, becausepressure from both above and below in a company tends to drive individuals in thatdirection. Pressure from above may link profit- maximizing behavior with rewards.Competition from below for seniority and position may also have a reinforcing effect.

A great deal of theoretical and empirical work needs lo be done before the fullimplications of the agency model are clear. Nevertheless, the approach does suggest



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another avenue through which managers may be influenced in the direction of profit-maximization.

The arguments for and against the assumption of profit-maximization are difficult tobalance in order to reach an unambiguous conclusion. Nevertheless, there are sufficientcounter-arguments Co the managerial criticisms for economists to be reasonably

comfortable in maintaining that assumption as the foundation for their model of the firm.

THE BEHAVIORAL MODEL OF THE FIRM

'Behavioral' criticisms of models of the firm

The 'managerial' models of the firm stem from criticism of the profit-maximizingassumption, on the grounds that in an era when ownership and control are separate, andmany firms compete in relatively comfortable oligopolistic market structures, managersare able to direct the resources of companies towards their own ends. In many other

respects the managerial models share similar characteristics with the orthodox textbookmodel of the firm. It is assumed that the firm is a single entity, being capable of havingobjectives, even if these are held by a group of managers, and the firm is seen as takingand implementing decisions. The models outlined above are all optimizing models and itis also assumed that the firm has certain knowledge of the cost and demand conditionsfacing it. In many respects the managerial models differ from the orthodox only in thatthey begin with a different assumption with respect to the firm's objective.

A much more radical attack on the orthodox model of the firm, which also impliescriticism of the managerial models, has been made by a group of theorists referred to asthe 'behavioral school', building on seminal work by Simon (1959) and Cyert and March(1963). In this approach attention focuses on behavior within the firm, which is not seenas a single entity, but as a set of shifting coalitions amongst individuals, each of whichhas their own set of objectives. The fundamental argument is that organizations cannothave objectives, only people can, and that to perceive a firm as having an objective is anexample of 'reification', confusing an abstract concept with a real entity.

In addition to rejecting the notion that a firm can have objectives, the behavioral theoristsalso reject the assumption that those taking decisions are perfectly informed. Theassumption of certainly is abandoned and emphasis is placed on the idea that mostorganizations are so complex that the individuals within them have only limitedinformation with respect TO both internal and external developments.

The behavioral alternative

The behavioral model of the firm is therefore very different from either the orthodoxmodel or the managerial models. It is not a 'holistic' model in that the firm is not seen as asingle entity. It is not an optimizing model where the firm achieves the best possibleperformance with respect to its objective, and it is not based upon the assumption ofcertainty. In place of these features of the other models it contains a number of keyelements.



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First, the 'firm' hardly exists, consisting as it does of a group of individuals who formcoalitions and alliances amongst themselves based upon common interests orcharacteristics, departmental loyalties or simple personal affinity. As a result the firmhas multiple objectives which are in conflict with each other and which cannot bereconciled through a concept like the utility function, which gives a weight to eachobjective and allows an overall 'score' to be achieved. The accountants in a firm may

wish to keep the level of stocks down in order to reduce the costs of holding them. At thesame time the sales force may wish to hold a high level of stocks in order to be able tomeet orders quickly. The research department may wish to employ a large number ofqualified scientists, while the marketing department would prefer to spend more onadvertising. Longer established employees may wish to avoid interruptions to theirroutine while newly employed executives may be anxious for change. Each individualwill themselves have multiple objectives, arising from their personal histories,preferences and position within the firm and these multiple sets of objectives cannot bereduced to any simple overall statement, which explains what the organization as a wholeis attempting to achieve.

The second major feature of the behavioral model, which distinguishes it from thoseoutlined above, is that decision-makers exhibit 'satisficing' behavior, rather than'optimizing' behavior. Neither the firm nor its component coalitions, nor individuals, areseen as attempting to maximize or minimize anything. Instead, each person or group hasa 'satisficing' level for each of its objectives. If these levels are reached, they will not seekfor more, in the short term at least, but if they are not met action will be taken in order toremedy the problem.

An important consequence of satisficing behavior is that firms acting in this way will notkeep costs down to a minimum. Instead they will exhibit 'organizational slack', incurringhigher costs than are absolutely necessary,

A third feature of the behavioral model is that action within the firm takes the form of'problem-oriented search using rules of thumb'. If one of the multiple objectives is notmet, so that someone within the firm is dissatisfied, a search will take place for a meansof meeting that objective. However, the search will be fairly narrow, relating solely to theobjective which is not being met, and the firm will use rules-of-thumb to attempt to putthe problem right. These rules-of-thumb are not arrived at through any detailed analysis,but are a function of the past experience of the firm and the people within it. For instance,if revenue falls, the firm may automatically raise its price, because that has been tried inthe past, and appeared to be successful.

Fourthly, the aspirations of [he individuals within the firm, which determine the levels ofeach objective with which they will be satisfied, change over time as a result of'organizational learning'. If a firm succeeds in meeting all of its objectives for a periodof time then eventually the individuals and groups will raise their aspiration levels,demanding more of whatever it is they care about. Eventually a situation will be reachedwhere not everyone achieves 'saiisficing' levels with respect to all of their objectives, atwhich point a problem-oriented search will lake place to seek a solution' to the problem.If one is found, the process of gradually increasing aspirations can continue. On the otherhand, if a solution is not found despite a number of searches' aspiration levels withrespect to the particular variable concerned will have to be reduced.



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Clearly, the behavioral model is very different to the others, which have been considered,and describes a number of very familiar features of organizational life. In many respectsit is descriptively more realistic than either the orthodox or the managerial models and isvery attractive for that reason. However, it also has to be recognized that it has relativelylimited use-value in addressing the questions with which managerial economics is

concerned. If we consider the positive question of 'how do firms respond to changes intheir environment?' the model offers little assistance, as it focuses entirely within thefirm. If we consider the normative question 'can we identify the decision-rules whichfirms should follow in order to meet their objectives?' that question is not addressedeither by the behavioral model. On the other hand, a firm which conforms well to thedescription set out by the behavioral theorists could behave in exactly the same way withrespect to price and output decisions as the profit-maximizing firm, or the firm describedby one of the managerial models. If the shareholders are a powerful group within the firmand will only be satisfied with maximum profit, and if employees and managers areconcerned for the firm's survival, the process of organizational learning may lead the firmtowards profit-maximization. For the purposes of managerial economics, then, the

behavioral model is of relatively limited usefulness.

The concept of X-inefficiency

A useful concept which links the behavioral model, and the managerial utility model, isthat of 'X-inefficiency'. In the standard, neo-classical, profit-maximizing model it isassumed that the firm incurs the minimum cost achievable for the level of output beingproduced, given the set of plant and equipment which has been installed. In terms of thediagram, the firm is on its cost curve. Such a firm may be described as being 'X-efficient'or 'operationally-efficient'. However, this may not be the case. A firm which ismaximizing managerial-utility, for instance, will tend to spend more on staff and on'perks' for the management than is necessary, in which case it may be said to be 'X-inefficient'. In terms of a diagram, it will be above its cost curve, as shown in Fig. 3.9.Similarly, a firm which conforms to the behavioral model will incur higher costs than arestrictly necessary and be X-inefficient, or have 'organizational slack'. Liebenstein(1966) emphasizes the importance of X-inefficiency and considers the factors which arelikely to encourage or discourage it. This analysis draws together a number of issuesalready considered above.

In the first place, the degree of X-inefficiency will be partly determined by factors whichare internal to the firm. If contracts between principals and agents (the owners, managersand workers) are not as efficient as has been suggested above then workers



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SAC

Average cost

incurred

Level of output Outputproduced

Fig. 3.9 An 'X-inefficient' firm

and managers will not be motivated to keep costs down, and the firm will be X-inefficient. If larger firms are more difficult to control, with a greater degree ofbureaucratic rigidity, then they will also tend to be more X-inefficient.

The second set of factors which determine the degree of X-inefficiency is to be found inthe external environment in which the firm operates. If the firm is forced by itsenvironment to aim for maximum profit, it must eliminate X-inefficiency. On the otherhand, if the management has the discretion to avoid profit-maximization it will allow itscosts to rise above the level which is strictly necessary. The environmental factors whichlead to X-inefficiency are therefore the converse of the factors which force the firm toaim for maximum profits. If shareholdings are diffused amongst a large number ofrelatively ill-informed small shareholders there will be little pressure from that direction.If the threat of take-over is limited, perhaps because the firm is too large to be underserious threat, or because anti-trust legislation prevents take-over, then the likelihood ofX-inefficiency is correspondingly higher.

Similarly, the degree of X-inefficiency will tend to be higher as the market structure inwhich the firm operates is less competitive. If [here are a small number of competitiverivals who are able to avoid direct competition with each other, and they are protected byharriers to entry into the industry, then there will be few penalties for slackness and X-inefficiency is correspondingly more likely to result.



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ILLUSTRATION

Ownership, control and performance in UK firms

Ever since Berle and Means drew attention to the separation between ownership andcontrol it has been recognized that firms which are owner-controlled (OC) may behave in

ways which differ from firms which are manager-controlled (MC), Holl (1975) providesan interesting example of an empirical study which attempted to identify the linksbetween the type of control and the performance of firms.

The starting point for the analysis lay in two sources of data. The first was a study byFlorence (1961), which provided data on ownership patterns for nearly 300 UK firms.This was used to divide 1'iniis into OC and MC firms on the basis of the followingcriteria:

A firm was considered OC if

(a) more than 50 per cent of voting shares were owned by one personor(b) 20- 50 per cent were owned by the largest shareholder, or at least 20 per cent

were held collectively by the largest 20 shareholdersand(c) the main vote holders were persons or the board of directors own more than 10

per cent of the shares or two or more members of the board are amongst thelargest 20 shareholders

All other firms were considered MC.

The second source of data was a data bank in Cambridge (UK), which providedinformation on company performance, which was measured with respect to profitability,growth, the distribution of profitability over time, and the firms' distribution ratio.

Holl then used a variety of 'managerial models' to develop hypotheses about thedifferences in performance to be expected between OC and MC firms. First, the Marrismodel is invoked to suggest that MC firms would tend to have higher growth rates andlower profits than OC firms. Secondly, it is argued on the basis of models developed byBaumol (1959) and Monsen and Downes (1965) that MC firms will exhibit less variationin profit from year to year and less skewness in their distribution over time than OCfirms. (The argument is essentially that in MC firms there is an asymmetry between thepunishments and rewards arising from poor or good performance. Poor performance ispunished but good performance is not well rewarded. As a result, the managers of MCfirms attempt to maintain steady profits over time, thus avoiding punishment while notsacrificing rewards.)

Thirdly, following Florence's argument, it is suggested that MC firms will tend to ploughback profits, while OC firms favor the distribution of dividends.Having developed a series of hypotheses, Holl then used a relatively sophisticatedstatistical technique known as discriminant analysis, in order to test them. This essentially



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consists of dividing the data set into two groups, OC and MC, and then measuring thestatistical 'distance' between them.

The results suggested a number of conclusions. For OC firms the profit rate was higherand the growth rate lower, as suggested by The Marris model, while both the varianceand skewness of their profits were greater, which was also as predicted. Those results

were statistically different from zero, which is one measure of success, but if theequations fitted were used with the original data to predict which class of firm each of theobservations would fit into, almost 40 per cent of firms would have been mis-classified.The discrimination achieved was not, therefore, very sharp.

Holl's first set of results were arrived at by examining the full sample of firms available.However, that approach could involve the introduction of biases arising from variableslike firm size and market structures. In order to control for that possibility the resultswere re-calculated for matched samples. First, OC firms were matched with MC firms ofequal size, which fed to very little change in the results. Secondly OC firms werematched with MC firms in the same industry, which gave statistically insignificant

results. The results with respect to profitability and the growth rate therefore suggest; thatcontrol type has no significant impact on firm performance. Similar calculations werecarried out with respect to the distribution ratio and similar results emerged.

These findings are significant for [he debate on the importance of managerial theories ofthe firm. The evidence suggests that MC firms are in fact forced 10 behave in the sameway as OC firms, in which case the managerial models are redundant. Managers mighthave different personal objectives from the shareholders but they do not have theindiscretion to indulge themselves in the pursuit of those objectives to the neglect of thecompany's owners.



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REFERENCES AND FURTHER READING

W. Baumol, '0n the Theory of Oligopoly', Economica, 1958W. Baumol, Business Behavior, Value and Growth, (New York, Harcourt, Brace and

World, 1967)A.A. Berle and G. Means, The Modern Corporation and Private Property, (New, York,

Macmillan, 1932)R. Cyert and J. March, Behavioral Theories of the Firm, (Englewood Cliffs, Prentice-Hall1963)

E. Fama. 'Agency Problems and the Theory of the Firm', Journal of Political Economy,1980

P.S. Florence, Ownership Control and Success of Larger Companies, (London, 1961)R. Fox, 'Agency Theory: A New Perspective',Management Accounting, 1984P. Holl, 'Control Type and the Market for Corporate Control in Large US Corporations',

Journal of Industrial Economics, 1977H. Liebenstein, 'Allocative Efficiency vs X-Efficiency,' American Economic Review,

1966

R. Marris, The Economic Theory of'Managerial Capitalism,' (London, Macmillan.1964)R.1. Monsen and A. Downs. 'A Theory of Large Managerial Firms'. Journal of PoliticalEconomy, June 1985

H. Simon, 'Theories of Decision-Making in Economics and Behavioral Science',American Economic Review, 1959

J. Williamson, 'Profit, Growth and Sales Maximization,' Economica, 19660. Williamson, 'Managerial Discretion and Business Behavior,' American EconomicReview, 1963



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SELF-TEST QUESTIONS

1. In which of the following models will the firm incur higher costs than are

necessary?

(a) Baumol's revenue-maximizing model(b) Williamson's managerial utility model

(c) Marris's model(d) the behavioral model(e) oligopolistic market conditions(f) stock option schemes for managers

2. Explain whether each of the following will make firms more likely or less

likely to adopt profit-maximization as their objective.

(a) an anti-trust policy which forbids take-overs(b) powerful, well-informed shareholders(c) an efficient stock market(d) Profit-maximizing

(e) Revenue-maximizing, with a profit constraint(f) Managerial utility maximizing

3. Which of the following concepts are compatible with the behavioral model of

the firm?

(a) Optimizing(b) satisficing(c) certainty(d) aspiration levels(e) rules of thumb

4. If fixed costs rise, what will happen to the level of output in each of the

following models?

(a) profit maximizing(b) revenue maximizing with profit constraint(c) managerial utility maximizing

5. Which firm would you expect to have the highest share price?

(a) a profit-maximizer(b) a revenue-maximizer(c) a managerial utility maximizer

EXERCISE

Explain the differences between the neo-classical theory and the X-inefficiency theory ofthe firm.



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i Adopted for instructional purposes from Davies, Howard. (1991). Managerial economics, 6th. ed. PearsonEducation: Harlow, England. (T.N. )

Documents

ME -Business Objectives and Models of the Firm - 10